Spotify technology(NYSE: SPOT) has been one of the best-performing tech stocks in the world since going public in 2018. However, the journey has been bumpy. Shares have delivered an annual total return of 19%, compared to 14% for the S&P500 index, meaning Spotify has beaten the market for the past seven years.
However, in 2021 and 2022, the Spotify story looked bleak. The music and audio streaming platform suffered an 80% decline as investors worried about a lack of profitability with its business model. Since falling to $75 per share, the stock has staged a remarkable comeback over the past two years for the company, which is now worth nearly $100 billion in market cap.
And yet the stock is rarely talked about in investor circles, even after this run-up. Here’s the widely overlooked story about Spotify’s stock market comeback, and whether you should buy shares today.
The end of 2022 was a dark period for Spotify. This was the low point of the stock’s decline. Wall Street was concerned about the company’s deteriorating operating margin, which fell to negative 7% in the third and fourth quarters of that year.
Spotify’s operating costs grew faster than revenue due to its ambitious expansion into podcasts, advertising and other new segments. Gross margins also fell due to higher podcast content costs and expensive licensing deals.
In the two years since, Spotify’s margins have made a miraculous turnaround. The reason for this improvement is simple: there was discipline in spending. Layoffs and fewer content licensing deals have seen operating costs fall from their peak, while gross margins reached a record high of 31.1% in the third quarter of this year. At the same time, sales continued to grow, rising 19% year-over-year in the last quarter.
Greater spending discipline has led to a major improvement in operating margin, which reached a positive 11.4% last quarter, surpassing management’s previous goal of achieving a 10% profit margin, which it set at Investor Day in 2022 had put forward, exceeds. This is fantastic progress for a company that many believed would never turn a profit. That’s why the stock price has increased by a multiple of five in less than two years.
SPOT total operating costs (TTM), data from YCharts; TTM = after 12 months.
Sales growth has accelerated in recent quarters and reached 19% in the third quarter. Price increases around the world for premium subscriptions were the main reason for this growth. The company has managed to implement significant price increases in countries like the United States with little to no increase in customer churn, suggesting it is underpricing its premium music service.
Price increases are great for shareholders, but Spotify can’t make them every year. Other sources of revenue growth will come from the acquisition of new users and new segments outside of music.
Monthly active users (MAUs) grew 11% year-over-year last quarter to 640 million, with strong growth coming from places like Southeast Asia and India. With billions of people in these emerging mobile phone markets, there is plenty of room to grow in the coming years.
Hopefully, these new customers will not only engage with Spotify’s music service, but also other forms of audio content such as podcasts and audiobooks. The company recently launched audiobooks in some markets with great success, leading to accelerated growth for the category.
Another thing to highlight – and which should lead to further profit increases – is gross margin expansion. This metric reached 31.1% last quarter, up from 25% in 2022. The promotional music marketplace has helped drive better economic performance for the music industry. If this increase in gross margin continues in the coming years, the company will be able to transfer more profits to operating income.
The big question for investors is whether Spotify is a buy after this monster run. At the time of writing, the stock has a market capitalization of $97.5 billion.
Sales over the past twelve months amounted to $16.4 billion. If you believe in the pricing power, user growth, and new stories coming out of the audio segment, I think it’s likely that Spotify will grow its revenue at 15% per year over the next five years. Due to the increased scale and gross margin expansion, I believe it is likely that operating margin will increase to 15% over this five-year period.
Applying these estimates, five-year revenues will be $33 billion, while profits will be just under $5 billion. Using the current market capitalization of $97.5 billion, that equates to a price/operating result of approximately 20 in five years.
There’s no reason to sell your Spotify shares at this price, but it seems unwise to add to your position or start a new purchase today. If the company continues this impressive growth, in five years it will only be able to trade at an earnings ratio right around the long-term market average. These are high expectations for the stock. Stay on the sidelines (for now) with Spotify after its monstrous run in 2024.
Have you ever felt like you missed the boat on buying the most successful stocks? Then you would like to hear this.
On rare occasions, our expert team of analysts provides a “Double Down” Stocks recommendation for companies they think are about to pop. If you’re worried that you’ve already missed your chance to invest, now is the best time to buy before it’s too late. And the numbers speak for themselves:
Nvidia:If you had invested $1,000 when we doubled in 2009,you would have $348,112!*
Apple: If you had invested $1,000 when we doubled in 2008, you would have $46,992!*
Netflix: If you had invested $1,000 when we doubled in 2004, you would have $495,539!*
We’re currently issuing ‘Double Down’ warnings for three incredible companies, and another opportunity like this may not happen anytime soon.
See 3 “Double Down” Stocks »
*Stock Advisor returns December 9, 2024
Brett Schafer has positions in Spotify Technology. The Motley Fool holds and recommends positions in Spotify Technology. The Motley Fool has a disclosure policy.
Meet the Monster Stock That Continues to Crush the Market was originally published by The Motley Fool
